Chapter 10: Provisions and Contingencies

Question 1

What does IAS 37 say about the key criteria of a liability?

Answer 1

A provision is a liability of uncertain timing or amount.
A liability is a present obligation of the entity to transfer an economic resource as a result of past event and is a duty/responsibility that the entity has no practical ability to avoid

Question 2

What does IAS 37 say about the key criteria of a provision?

Answer 2

Simply:

• present obligation relating to a past event with a probable economic outflow before the year end
• can be measured reliably
• probable means a greater than 50% probability

If one or more of these is not met, a provision may not be recognised and it is appropriate to consider the accounting treatment of a contingent liability instead

Question 3

What never leads to a provision?

Answer 3

Future operating losses as they arise on day-by-day basis and are avoidable as you can cease operations

Question 4

What should the amount recognised as a provision be?

Answer 4

The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the reporting date.

Question 5

What can management consider when generating an estimate?

Answer 5

• Past experience
• Advice of experts
• Market forecasts

Question 6

How do you measure a provision in a single transaction?

Answer 6

For a single obligation, such as a legal case, the most likely outflow will generally be the best estimate unless other possible outcomes are mainly higher or lower.

If provided with a number of possibilities, this is the outcome with the highest probability. Note than an average of possible outcomes will not be appropriate for a single transaction.

Question 7

How do you measure a provision in a large population?

Answer 7

Where the provision involves a large population of items such as standard warranties, the expected value method, essentially a case of taking a weighted average of outcomes, should be used to derive the best estimate

The provision should be discounted to present value where the effect of this is material. This will be subsequently unwound giving rise to a finance cost in the SPL - for the exam this is considered necessary if the cash flow is a year or more into the future.

Question 8

What are the correct accounting entries to set up a provision?

Answer 8

Dr Expense (SPL)
Cr Provision (SFP)

Question 9

What are the variants in the accounting entries for provisions?

Answer 9

• The relevant expense category will depend upon the subject of the provision, e.g. a warranty claim might be charged to cost of sales
• The debit entry for a provision for dismantling costs will be to property, plant and equipment rather than to the statement of profit or loss. This will subsequently be released to the statement of profit or loss through depreciation

Question 10

How do you account for a provision that is no longer needed?

Answer 10

Provisions should be reviewed at each reporting date. If it no longer meets the recognition criteria it should be derecognised:

Dr Provision (SFP)
Cr SPL

Question 11

How do you account for an increase in the probable outflow of a provision?

Answer 11

Dr Expense (SPL)
Cr Provision (SFP)

Only the movement of the provision is accounted for

Question 12

How do you account for a decrease in the probable outflow of a provision?

Answer 12

Dr Provision (SFP)
Cr Expense (SPL)

Only the movement of the provision is accounted for

Question 13

How do you account for the use of a provision?

Answer 13

A provision may only be used for the expense it was originally created for.
Where relevant expenditure is incurred, the double entry to record this is:

Dr Provision (SFP)
Cr Cash 

Any difference between the opening provision and the amount paid should be recognised in the statement of profit or loss

Question 14

Should you consider the expected disposal of assets when making a provision?

Answer 14

Gains and losses from the expected future disposal of assets should not be considered when creating provisions, as there is no present obligation. They arise in the future

Question 15

What is an onerous contract?

Answer 15

IAS 37 Provisions, Contingent Liabilities and Contingent Assets defines an onerous contract as ‘a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it’ (IAS 37, para 68).

Question 16

What are unavoidable costs? How do you treat onerous contracts and provisions?

Answer 16

Remember that unavoidable costs are classed as the lower of the cost of fulfilling the contract and any compensation or penalties arising from failure to fulfil it.

A provision for the cost should be recognised as an expense in the statement of profit or loss in the period when the contract becomes onerous.

In subsequent periods, this provision will be reduced by the payments made

Question 17

What is restructuring?

Answer 17

IAS 37 Provisions, Contingent Liabilities and Contingent Assets defines restructuring as ‘a programme that is planned and controlled by management, and materially changes either:

the scope of a business undertaken by an entity or
the manner in which that business is conducted’ (IAS 37, para 10).

Question 18

When can a provision for restructuring be made?

Answer 18

A provision for restructuring may only be made if:

• a detailed, formal and approved plan exists and,
• the plan has been announced to those affected (generally employees).

Question 19

What should a provision for restructuring do?

Answer 19

The provision should:

• include direct expenditure arising from restructuring
• exclude costs associated with ongoing activities.

Question 20

What happens if an obligation exists at the date of acquisition to dismantle/restore an item of PPE?

Answer 20

If an obligation exists at the date of acquisition to dismantle/restore an item of PPE at the end of its useful life then the costs of the site restoration are treated as directly attributable to bringing the asset to its present location and condition

They should therefore be capitalised in accordance with IAS 16 Property, Plant and Equipment. Since these costs will be incurred in the future it will be necessary to discount these costs if considered material by the entity

Question 21

How do you populate a disclosure note?

Answer 21

• Balance b/f
• Statement of profit or loss (balancing figure)
• Insert the amount utilised (i.e paid in cash) during the year, which again will be given in the question
• Balance c/f (best estimate of the future outflow, or expected value if appropriate)

Question 22

What are the three possible treatments of a potential liability?

Answer 22

There are three possible treatments of a potential liability:

• recognise a provision
• disclose as contingent liability or
• do nothing.

Question 23

What do you do if the probability of the obligation occurring is remote?

Answer 23

Ignore (nothing is recorded)

Question 24

What do you do if the probability of the obligation occurring is possible?

Answer 24

Disclose as a contingent liability ( no more than 50% of a chance )

Question 25

What do you do if the probability of the obligation occurring is probable?

Answer 25

Provide - assuming all of the recognition criteria have been met

Question 26

How do you disclose a contingent liability?

Answer 26

IAS 37: ‘a brief description of the nature of the contingency and, where practicable:

• an estimate of the financial effect (…)
• an indication of uncertainties relating to the amount or timing of any outflow; and
• the possibility of any reimbursement

Question 27

When do you recognise an uncertain asset?

Answer 27

• remote - ignore (nothing is recorded)
• possible - ignore (nothing is recorded)
• probable - disclose as as a contingent asset
• virtually certain - recognise the asset

Question 28

How do you disclose a contingent asset?

Answer 28

A contingent asset is a probable asset arising from a past event. IAS 37 requires the following to be disclosed:

• a description of the nature of the contingent asset
• where practicable an estimate of the financial effect

Question 29

How do you recognise a virtually certain asset?

Answer 29

If it is virtually certain that the company will have a benefit that can be reliably measured, an asset can be recognised:

Dr Receivable
Cr SPL (other income)

Question 30

When can a reimbursement be recorded?

Answer 30

IF;

• the reimbursement is virtually certain, and
• the settlement of the claim upon which the reimbursement depends is probable
  then the company should record both a provision and associated asset

Question 31

What are the rules for the recording of a reimbursement?

Answer 31

• The asset and liability must be disclosed separately on the statement of financial position
• SPL amounts may be netted off
• The amount of the asset may not exceed the amount of the provision